Cost Plus Pricing: Definition, How It Works, and More

Cost-plus pricing is one of the most commonly used pricing methods. It helps a business calculate the total costs of production and set a fixed markup over it.

This approach is useful for retail and other businesses with several products. It offers a simple approach and it is understood easily by managers.

Let us discuss what is cost-plus pricing and what are its uses.

Cost Plus Pricing – Definition

Cost plus pricing is a method that calculates the selling price of a unit of product or service by simply adding a fixed percentage of markup to the total costs.

The calculation of total costs includes raw materials, direct labor, variable costs, and indirect product costs. It means this method includes all direct and indirect costs linked with the product or service.

Cost plus pricing is also called markup pricing strategy. A business adds a percentage of the desired markup to the total cost of production to generate profits.

It is important to understand that profit markup and profit margins are two different calculations.

Profit Markup

It is the percentage profit in terms of the total cost. It means the business adds a percentage of markup to total costs to arrive at the profit.

Profit Margin

In this method, the profit is shown as a percentage of the selling price. It means the business sets a selling price first.

The cost-plus approach is the simplest of pricing methods.

Cost Plus Pricing Formula

The selling price of a product or service can be calculated step-by-step as well (discussed below). The formula to calculate the selling price using the cost-plus method can be derived as below.

SP = TC × (1+Markup)

Where:

  • SP= Selling Price      
  • TC= Total Cost and Markup= % or fixed amount

How Does Cost Plus Pricing Work?

Cost-plus pricing is one of the most common methods to calculate the selling price of a product or service. A business can add all the costs (direct and indirect) of producing a product and then add the desired markup to that amount.

Cost-plus is more suitable for businesses that produce products in bulk. When there is product or service differentiation, this method does not offer ideal pricing solutions.

Although this method considers the full cost of the product, it ignores several factors. For instance, this method does not consider external market factors such as competitors’ prices or consumer demands.

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This approach works best for retail businesses. These businesses such as groceries, clothing, and stores have a wide range of different products. They can add different markup rates to different products easily. Thus, they can keep profits as they are covering all costs.

Businesses may set higher prices using this method. They must set markup percentages carefully. Also, they must consider the consumer demands and their willingness to pay the selling price for a particular product or brand.

Steps to Calculate Cost Plus Pricing

When a business knows the total cost of a product, it can simply add the desired markup to that cost. It is a straightforward calculation for a retailer that purchases different products in bulk from the wholesalers. However, businesses can adopt a step-by-step approach to calculate the selling price as well.

First Step

The first step is to calculate the total cost of a product or service. Total costs include direct and indirect product costs. In other words, a business must add all fixed and variable costs.

Common examples of fixed and variable product costs include:

  • Direct Material and Direct Labor
  • Overhead Costs (Utility, indirect labor, indirect material)
  • Marketing and selling
  • Transportation
  • Building Rent (for the production facility)

Second Step

Once a business calculates the full costs of production, the next step is to calculate the cost per unit of a product. It can be calculated simply by dividing the total costs by the total number of products produced.

Third Step

Finally, the business can add a percentage of markup to the cost per unit calculated in the second step. A business can add a dollar value to the markup as well. However, the percentage gives an easier option for analysis and profit calculations.

NOTE: A business can also directly calculate cost per unit if the data is available for direct material, direct labor, and overhead costs in step two above.

Example of Cost Plus Pricing

Suppose a company ABC produces clothing items. We consider one of its products as an example to derive the selling price using the cost-plus method.

Suppose ABC company has the following data available for producing one unit of its T-Shirts.

Step 1:

Raw Material = $ 40

Direct Labor = $ 10

Overhead Costs =$ 15

Other fixed costs =$ 20

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Total Cost of 1 unit = $ 85

Step 2:

Since ABC company has already calculated the cost per unit, this step can be skipped.

Step 3:

ABC company can use profit markup or profit margin to calculate its desired selling price per unit.

At 20% profit markup:

Selling price = $ 85 × (1+ 20%) = $ 102

At 20% profit margin:

Selling price = C/ (1-profit margin) = 85/ (1-20%)

Selling Price = $ 106.25

Although both types of selling prices calculated in step 3 are acceptable, the cost-plus method prefers adding a percentage markup to the cost per unit.

When to Use Cost Plus Pricing?

Retailers and Business as Agents

The cost-plus pricing model is useful for retailers and businesses that work as agents. The businesses purchasing products from the wholesalers can add their markup percentages to different products and keep their profits.

Businesses that pursue cost leadership methodology can use the cost-plus pricing model. They can use the marketing tools to convince customers with a transparent cost-plus pricing model.

Cost-Plus Contracts

Another common use of this approach is in the cost-plus contracting industry. These contracts are commonly used in the construction industry.

A construction company undertakes a construction project. It calculates the total cost of construction as agreed with the client through a contract. Both parties then agree on a fixed percentage of markup that the construction company adds to the total costs.

This approach is suitable for businesses that can adopt a transparent pricing policy. It can become a competitive advantage for them when the customer knows how much their service provider charges them on top of the total costs.

When Cost Plus Pricing Should not be Used?

Although cost-plus pricing is a widely used method it does not help every type of business.

It should not be used for businesses that provide discrete products or differentiating products. Businesses with highly customized products should not use this method.

Similarly, some businesses such as software as a service cannot utilize this approach to their best advantage. These services cannot be evaluated in terms of the cost of production. Highly customized software services provide long-term benefits to users. Thus, a cost-plus pricing model does not provide the right choice here.

This method does not consider external pricing factors such as market competitors. Thus, businesses with highly competitive markets should not adopt this approach. It also ignores the maximum selling prices customers are willing to pay for a certain product.

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In short, businesses with customized products, competitive markets, and sophisticated services should not adapt to the cost-plus pricing.

Advantages of Cost Plus Pricing

It is a traditional and commonly used method. However, you should compare its pros and cons to make the right decision.

Here are a few advantages of this method.

Simple and Easy Method

Cost-plus pricing is a simple and easy method to use. It can be applied across several types of businesses. It is a widely used and understood method.

Consistent Returns

A company can keep a consistent rate of return when using this approach. The business adds a fixed percentage of markup to the total cost of products. If the cost goes up, the markup as a percentage will keep the same rate of return.

Useful in Cost-Plus Contracts

Businesses that offer services on a contractual basis can use this method effectively. Particularly, construction businesses with cost-plus contracts.

Provides Flexibility

Since a business can keep its rate of return and profits to the required levels, it offers great flexibility. A business can adjust its markup percentage considering market competition as well.

Changes in Pricing can be Justified

When a business changes its selling prices due to any reason, it can justify the markups over it. This approach helps a business apply a fixed markup and keep its pricing policy transparent.

Disadvantages of Cost Plus Pricing

This approach has some disadvantages as well.

It Ignores Market Competition

The company will simply add a markup to its cost of production. It does not consider market competition and the willingness of buyers to pay a certain selling price.

Selling Prices Can be Inaccurate

This approach may not provide a suitable or accurate selling price to a business. If the business fails to achieve a certain sales volume, it may not recover the operating costs of the business.

Compromised Operating Efficiency

It does not motivate a business to increase its operating efficiency that can reduce the total costs of production. A business can simply add a percentage markup on top of the costs to calculate its profits.

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